Ready for Prime Time: Discovery’s Tax-Free Spinoff

In a tax-free -- albeit complex -- spin-off Discovery Holdings reworks its subsidiary structure to become a pure play programmer.

In 2005, Discovery Holding Company (DHC) was spun-off from Liberty Media. Now, Discovery Holding is undertaking its own spin-off in conjunction with a series of restructuring steps that will culminate in its becoming a pure play programming entity. The hope is that the stock of Discovery Holding’s successor will be accorded a higher valuation by the market than is currently the case.

To reach its ultimate goal, the company has put forth a multi-step plan, carefully devised to be free from tax consequences. We believe the parties have succeeded — although the transaction is complex.

Discovery Holdings currently owns a two-thirds capital and profits interest in Discovery Communications LLC, the programming arm of the holding company family. The remaining one-third interest in Discovery Communications is owned by a partnership known as the A/N (for Advance Newhouse) partnership. Discovery Holding also owns 100 percent of the stock of Ascent Media.

The presence of Ascent in the prior separation of Discovery Holding from Liberty Media enabled the first spin-off to be completed on a tax-free basis. Discovery Holdings’ active business status, with respect to the prior spin-off, was premised on its ownership of a controlling interest in Ascent. It was, therefore, Ascent’s active business on which the parties had relied to satisfy the active business test.

The new transaction on which Discovery Holding is embarking entails the following steps:
• Discovery Holdings will distribute its stock in Ascent Media to its shareholders;
• A new company, named Discovery Communications Inc. (DCI), will be organized, and DCI will form a transitory subsidiary (MergerSub) which will merge with and into Discovery Holdings. In the merger, the shareholders of Discovery Holding will have their stock converted into various classes of voting and non-voting common stock of DCI, and the stock of MergerSub owned by DCI will be converted into stock of Discovery Holding. Thus, Discovery Holding will become a wholly-owned subsidiary of DCI, and the former shareholders of the holding company will become shareholders of DCI;
• As part of the overall plan, the A/N partnership will transfer its interest in Discovery Communications to DCI in exchange solely for Series A and Series C convertible preferred shares of DCI.

Global Section 351 Exchange

There is every reason to believe that the spin-off of Ascent Media will be tax-free to both Discovery Holdings and its shareholders. The spin-off, which is clearly being undertaken for one or more valid corporate business purposes, seems to meet the active business test. As a result, the spun-off corporation, Ascent, will be engaged in the active conduct of a trade or business immediately after the spin-off and clearly, Discovery Holdings will also be so engaged.

The Internal Revenue Service has ruled that a partner is deemed to be conducting the business of a partnership in which it has an interest so long as that interest represents a “significant” interest in the partnership. (See Rev. Rul. 2007-42, I.R.B. 2007-28, June 21, 2007.) A one-third interest in partnership capital and profits should suffice. Also, Discovery Holdings is in possession of a two-thirds capital and profits interest with respect to Discovery Communications. So Discovery Holdings would be viewed as conducting the trade or business in which Discovery Communications is engaged, even if it does not have active and substantial management functions with respect to Discovery Communication’s business.

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